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Profit Margin Squeeze Continues.

The two charts below offer clues for evaluating the risk of profit margin squeeze in the current economy. One is the ratio of crude to finished goods in the Producer Price Index. The other is an indicator constructed from two data series in the Philadelphia Fed’s Business Outlook Survey through today’s release. It is the spread between the Philly Fed’s prices paid (input costs) and received (prices charged) data.

A major risk factor for margin squeeze is the increase in commodity prices over the past several months with the price of oil and gasoline as the dominant factor.

So let’s take a broader view of these two indicators by viewing them within the context of inflation as measured by the Consumer Price Index. As the first chart clearly shows, the all-time high in the PPI crude-to-finished-goods ratio was in July 2008, the same month that crude oil and gasoline prices in the U.S. hit their all-time highs. The previous ratio high was in the summer of 1973, a few months before the outbreak of the October Arab-Israeli War and the Oil Embargo. Inflation had already been rising in a series of waves since the mid-1960s. But Middle-East events of 1973 were the primary trigger for the nearly ten years of stagflation that followed.

The August 2011 ratio is at the 97th percentile of the 774 data points in this series, down slightly from the 99th percentile in April, but clearly in the danger zone.

The Philly Fed Prices Paid Minus Prices Received Index is an extremely volatile series, which I’ve illustrated by using dots for the monthly data points. The volatility is so great that the value for any specific month can’t be taken very seriously. However, to highlight the underlying pattern, I’ve included a 12-month moving average (MA). The date callouts show that the comparable levels in the past were associated with inflationary peaks. The September ratio has dropped to the 67th percentile of the 521 monthly data points in this series. However, the 12-month MA is only 2.0% below the all-time high set in March.

By official government metrics, the CPI and PCE, inflation is not a near-term threat. In fact, the Federal Reserve has been working hard to raise the level of core inflation.

Of course, there are many differences between the inflationary decade of the 1970s and the present, not least of which is the rate of unemployment. In August 1973 (first chart above), unemployment was at 4.8%. The latest unemployment number from the Bureau of Labor Statistics is 9.1%. Also, U.S. demographics today are quite different. The oldest Boomers were turning 27 in 1973. They were at the beginning of their careers with decades of wage increases in their expectations. This year they are turning 65, and many are already on Social Security as their main source of income.

At present, in light of the unemployment rate and the ongoing demographic shift, rises in commodity prices probably pose more risk of continuing margin squeeze than run-away inflation. Some degree of cost-push inflation may be a near-term risk, but the demand-pull inflation we saw in the 1970s is difficult to envision in the U.S. economy of this decade.

On the other hand, the volatility of many commodity prices, especially oil, keeps the topic of profit margin squeeze on the table.

The next Philly Fed Business Outlook Survey will be released on October 20, 2011.

About The Author

My original dshort.com website was launched in February 2005 using a domain name based on my real name, Doug Short. I’m a formerly retired first wave boomer with a Ph.D. in English from Duke. Now my website has been acquired byAdvisor Perspectives, where I have been appointed the Vice President of Research.

My first career was a faculty position at North Carolina State University, where I achieved the rank of Full Professor in 1983. During the early ’80s I got hooked on academic uses of microcomputers for research and instruction. In 1983, I co-directed the Sixth International Conference on Computers and the Humanities. An IBM executive who attended the conference made me a job offer I couldn’t refuse.

Thus began my new career as a Higher Education Consultant for IBM — an ambassador for Information Technology to major universities around the country. After 12 years with Big Blue, I grew tired of the constant travel and left for a series of IT management positions in the Research Triangle area of North Carolina. I concluded my IT career managing the group responsible for email and research databases at GlaxoSmithKline until my retirement in 2006.

Contrary to what many visitors assume based on my last name, I’m not a bearish short seller. It’s true that some of my content has been a bit pessimistic in recent years. But I believe this is a result of economic realities and not a personal bias. For the record, my efforts to educate others about bear markets date from November 2007, as this Motley Fool article attests.